But only vertical diversification (spreading your wealth between asset classes) can help to offset the risk of a disaster in the entire asset class.

Decimal pointlessness

Every so often a reader will leave a comment on Monevator that includes something along the lines of “…my 30-year plan is based around the 5.3436% real return I’ll get from equities and…”

This is spurious precision.

It’s great to have a financial plan – vital for most people. And a plan needs to be fed by numbers, which for investors means expected returns.

These expected returns may be derived from what we’ve seen in the past or calculated from some predictions about the future.

But they are best guesses. Nobody is owed their expected return (and all investments can fail you.)

To some extent this is pedantry on my part, of the sort that occasionally infuriates my co-blogger, The Accumulator.

People are confused and scared enough about investing, he says, on discovering I’ve shoehorned another “probably”, “hopefully”, “likely”, or “if the gods are kind to us and we sacrifice the right chickens” into his copy.

But for me investing is all about understanding you’re working with your best guesses, not from a rulebook with the precision of a German train table.

He knows that, of course. You know that, too. And at the end of the day, my complaints might well be pedantic because when somebody asks me if they should invest in shares for their old-age, the first thing I do is point out the superior expected long-term returns (which I put a hoped-for number on) and the second thing I do is direct them to the great long-term returns from the past.

However after doing all that, I invariably then pin them to the wall and splutter crazily in their face like an Old Testament prophet about how nothing is guaranteed in this Earthly realm expect death and changes to taxes with every Budget from George Osborne.

The truth is much of what we take for granted in sensible investing – the need to diversify, the long-term time horizons, the benefits of low cost tracker funds – are at their heart founded on uncertainty, not its opposite.

We should never forget that.

A poor 50 years for shares

Even the past is an unreliable teacher, as two different articles looking at US returns demonstrated this week.

The first, from Bill Barker at The Motley Fool, pointed out that for all the ceaseless talk of an over-valued stock market, returns have actually tailed off in recent decades.

Barker writes:

I was born in the middle of 1965. A full 50 years have passed since then. That’s been enough time for me to get married, have three children, and sprout some gray hairs.

But it’s also enough time, I think, to consider whether it’s been a decent time to be invested.

If you had invested $1 in the S&P 500 on Jan. 1, 1966, and reinvested all dividends (and somehow endured no costs), then you would have ended up with $102.17 at the end of market trading on Dec. 31, 2015.

That’s 102 times your money. That sounds outrageously good. But was it?

Actually, it didn’t match historical averages.

The past 50 years’ stock returns, on the whole, haven’t quite been up to snuff compared with either the longer-term historical averages or the 50 years that immediately preceded that half-century.

Barker reports that the real1 return from US equities between 1916 to 1966 was 7.9%, whereas from 1966 to 2016 it was a mere 5.4%.

That’s interesting, I think, considering that many people would describe the past 50 years as the coming of age of global capitalism.

Why were returns lower? There are likely many reasons. The US started the 20th Century as pretty much an emerging market, for example, which suggests higher returns. The growing popularity of share investing over the century likely did pull down the returns compared to its earlier, wilder days.

And then there’s the possibility that the US market has actually done more badly than might have been expected in recent decades.

Perhaps we’re due a huge boom – it seems counter-intuitive for all the talk of bubbles and over-valuation, but the stupendous returns from bonds over the past 30 years does hint to me that we might be approaching some sort of reversal of fortunes.

A great 30 years for shares

Another massive reason for Barker’s weaker returns – a reason you should always consider when faced with such volatile data – is simply that the starting and ending points for that 50-year were particularly unfavourable for equities.

Looking at the other article I mentioned, this time from Bloomberg, brings this point home.

Bloomberg highlights a new McKinsey study that considers just the past 30 years for US equities, which the consultants call a “Golden Era” of inflation-adjusted returns.

True, they’re looking at bonds as well as equities. But still it’s interesting to consider that you could have a completely different frame of mind about how your investments will likely fair in the future depending on which article you happened to skim through over your toast.

McKinsey points to falling interest rates and the taming of inflation over the past three decades as reasons why investors did so well in the period. It thinks these could now reverse.

“We’ve had a wonderful 30-year period in terms of returns, way more than the 100-year average,” said Richard Dobbs, a McKinsey director in London.

“That era is coming to an end.”

He may well be right. He’s much too certain.

A strong 10 years ahead for emerging market shares?

Who really knows how the next 20 to 30 years are going to play out for the world, let alone for investors.

When I think about the pace of technological change, the way a company like Facebook can grow from nothing to over $300 billion in a little over a decade and capture the attention of a billion people a day, the coming era of robotics and AI, the likelihood of ecosystems collapsing, and what will happen if and when inflation returns to the Western world, I think it’s foolish to be adamant.

I’d happily use the McKinsey study as a well-researched guide to the future.

I wouldn’t bet my life on it being right.

Coincidentally, there’s research in The Telegraph this weekend that tries to predict future returns from factors such as credit availability and demographics, rather than from past returns.

Fund manager Barings has been crunching the numbers like this since 2003, which means it’s now getting itself a track record. A superficial eyeballing of the accuracy of its past predictions is quite impressive, especially considering that the cataclysm of the financial crisis in the mix.

Here’s what Barings predicts in terms of asset class returns for the next 10 years:

Predictions from Barings.

For the two cents it’s worth, this spread of returns does roughly accord with my own view of the world right now (and it makes me regret selling my high-yield bonds after a three-month pop in my active portfolio…)

But remember that most methods of forecasting returns have previously proven to be useless over the long-term. Barings might be having a good run, but it seems unlikely to have cracked the code.

Nobody knows for sure if it’s a good time to invest in shares

All this uncertainty doesn’t mean you shouldn’t have a well-planned approach to investing.

It means, rather, that you should definitely have a well-planned approach to investing.

For nearly everyone, attempting to precisely predict returns or to dodge stock market crashes based on some particular variable looking peaky are only likely to hurt the growth of their portfolio.

The biggest issue for most investors has not been the active vs. passive debate or investment costs — it’s been those who have latched on to the pessimistic parade of charlatans who have kept people out of the markets with scare tactics and fear mongering.

Being out of the market for the past 7-10 years has been far more damaging that any difference in mutual fund fees.

The drumbeat of negativity — persistent calls for double dip recessions, market crashes and the end of the financial system as we know it — has been nearly endless during this market recovery. […]

It’s possible that this could be one of the strongest bull markets some investors will see in their lifetimes. These types of gains don’t come around too often and are promised to no investor.

Even being invested in a mediocre fund would have given you pretty great annual returns over the past 3 and 5 years.

It was far more destructive to sit in cash the entire time because you were still nervous about the financial crisis.

If you think missing out on ten years is bad, you probably don’t want to see what would happen if you avoided at least some moderate dollops of equities in your pension planning for a lifetime.

Product of the week:CityAMreports on how IKEA has begun to stock solar panels online and in selected stores, ahead of a national roll-out. Despite the Government trimming the subsidies for solar installation, homeowners can reportedly still enjoy a 6% return and pay off their panels within 11 years.

Mainstream media money

Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.2

Book of the week: As an article in Quartz recently pointed out, the world’s smartest people read a lot of books. Correlation or causation? Surely a bit of both. Biographies are a big hit with these high-achievers, whether their role models hail from business or the Roman Empire.

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I know Richard from my time at the Firm. I like him and he’s a smart guy (although his strengths may lie even deeper in his uncanny sailing abilities: I’ve been soundly beaten by him more than once in a yacht). The MGI report is a classic bit of McK analysis: highlighting the one-off shocks that have benefited the growth of the past 30 years — of which there are many — and why they can’t occur again, as well as peering into the mists of bad stuff coming up. However, I think that like most Malthusian predictions it fails to take into account our ability to be surprised by the future. If you had sat down in 1986 and listed the good stuff that was coming you’d have missed all of the things on Richard’s list. Indeed, it would be another 10 years before the internet was widespread enough for McKinsey to have a single computer connected with a browser shared across the entire office. You’d also have missed the bad stuff too: the credit crunch and the dotcom bubble.

Although, in fact the predictions aren’t that dire, and there’s a definite hint of why in the Bloomberg interview: I’d rather live in a 4-5% world with 7bp fees than a 6-7% world with 2% fees. So do 30 year olds really have such a dire future? Cost of living are being cut by the internet and so the cost of FI is falling. A low yield world isn’t just a low return one: it’s a lower cost one (unless you are buying assets ).

The certainty of the delivery I find is actually more useful than a caveated approach that TA’s editor subjects him to. While all the ifs and buts and maybes may be a better representation of the truth, articles are a communication tool for an idea or a proposition which no-one ever takes at face value but builds into their own views. Ever wonder why we didn’t listen to the scientist on climate change for so long? They weren’t clear enough in their messaging for a very long time — allowing their scientific credentials to obscure the lobbying that was needed.

It’s great to have someone stand up and say “here’s how it is” — as it starts the cogs whirring in your own head: do I believe that? Do I believe his assumptions? What do I believe myself? How would that affect the output? Indeed it’s one of the reasons that — despite the spurious precision — I like to keep a mathematical approach to forecasting. You get to learn how the inputs affect the outputs, and that is critical to understanding where to place your efforts.

@mathmo — On the point of strategic imprecision, I’d perhaps agree if Monevator was a book, chapter one was a big caveat about uncertainty, and every chapter after therefore not required to belabor the point.

However nobody reads a blog from page one (and VERY few start at the home page). They arrive on a random old page like clueless astronauts on a strange world, sent here by Google to answer a question they’ve asked but very often aren’t yet equipped to truly understand.

I take this first (or second, or fifth!) contact very seriously.

You, me, TA, and even the house troll could probably spend an enjoyable evening in the pub debating whether the equity risk premium has permanently shifted or whatnot, but the blog has a wider remit. 🙂

That said, I do see the point of the other side, and that uncertainty may be confused with, well, confusion!

And TA will surely be glad of your vote of support, and no doubt bolster his case with it next time! 😉

“Being out of the market for the past 7-10 years has been far more damaging that any difference in mutual fund fees.” Ben Carlson

Am one of Ben’s greatest admirers, and while agreeing with the thrust of his argument about Asset Allocation outweighing the passive v active debate, think we ought to stop, pause, and think about this (straw man) statement, which is so very often put forward?

A few investors do indeed use extreme Tactical Asset Allocation, moving in and out totally from the most unpromising Asset Classes to the most promising Asset Classes, based on economic criteria, valuations, or plain accel/decel chartism. But this gives Valuation Driven Investment a poor dismissal!

To the contrary, many Valuation Driven Asset Allocators will note the various Asset Class Valuations as they evolve in a measured manner, will gradually adjust the Asset Class Allocations accordingly in a pre-planned proportional (not binary) process, following an Investment Plan. They are unikely to respond as suggested, in such a totally in or out manner!

Unfortunately the relative success or otherwise of Valuation Driven Investment is impossible to determine and compare, since it will vary from investor to investor, from method to method, and esp target reaching techniques where momentum can come into play.

Having said all that, most investors are indeed well advised to stick to a fixed Asset Allocation with occasional rebalancing. It is easy to understand, has a proven track record, needs no valuation measuring techniques (which is problematic), and controls risk/volatility to some extent.

By the way loved the 10 year expected returns chart. Food for thought!

The Guardian article on the UK as a savers’ paradise was interesting. It made the point that when you add up the ISA allowance, CGT allowance, interest allowance etc then UK savers can save quite a lot (and get a decent income) tax free.

It was just depressing that the article dressed it up as tax breaks for a ‘tiny majority’ of ‘the upper middle class’. I won’t use use up my full ISA allowance this year and I won’t next year when it goes up. But if you want to have a go at regressive govt decisions surely there are better targets than ISA limits? It just seems to give the impression that working hard to earn more than average (as RIT has) or save more than average (as most FIRE afficionados are) is weird and somehow ‘unfair’. Surely it makes sense to have a decent, even generous, straightforward saving structure but then to clamp down on Panama Paper style antics.

The easiest way for these articles to be wrong about long term returns would be to have a big fall from current stock and bond values in the next few years. Then the average returns over a 50 year period could more easily be in line with the 1966-2015 returns cited

‘A few investors do indeed use extreme Tactical Asset Allocation, moving in and out totally from the most unpromising Asset Classes to the most promising Asset Classes, based on economic criteria, valuations, or plain accel/decel chartism. But this gives Valuation Driven Investment a poor dismissal!’

A lot of big words there that I don’t fully understand. I have looked at CAPE values to try help to decide my geographical asset allocation. Sounds a bit like that.

As for individuals, I’m sure a very few people manage to achieve it over the long-term (although it’s notable that few of the great equity investors, Soros aside, seem to credit any of their success to it, Buffett included).

When it comes to observation of comments on Monevator and other online forums over the years, those touting tactical allocation type activities have been among the most wrong of all. (E.g. All the people who called us idiots for suggesting passive investors own government bonds, all the people who started calling the US too expensive to go near based on CAPE way back in 2012 (!) and so on).

Sorry, but I think the average reader should skim over your comment t the bit where you say “most investors are indeed well advised to stick to a fixed Asset Allocation with occasional rebalancing”.

p.s. I probably don’t explain this enough, but when I say “the average reader should be passive” I DO NOT mean “the average stupid reader should be passive, but the maths-wise or clever ones should do fancy active stuff.”

I mean two things. Firstly, a very few people can beat markets, I believe through skill. These people are so rare that they will soon suspect it already (if luck goes their way — bad luck can easily swamp any edge, and also give the illusion of one of course). So I will always include that standard caveat; many passive writers, perhaps even including my own co-blogger TA, would not, as he thinks skill is so vanishingly rare as to make it better to presume you’ve just been lucky. 🙂

Secondly, some people, such as me, will always meddle because we’re investing enthusiasts. Like some people will dress up in historical battle costume and recreate the Norman Conquest. We enjoy it. Doesn’t mean such people won’t get cut to pieces, return-wise. 😉

Because all these respond in a formulaic manner to whatever the market throws at them, they can IMHO all be deemed passive.
I.E. Not needing thought or decision making like TAA.

As an aside, always find the search facility on Monevator a good first port of call when unknowns arise.
Can’t find very much on Private Equity however!
Have I missed a link?
With more and more companies being taken off market, or never listed (a worrying trend), this seems to be an area worth contemplating for inclusion in our portfolios?

These labels and others are regularly mistaken, interchanged, or mis-applied in the literature and in discussions as TI/TA will be only too aware!

Interest in Investment Formulas (such as the favoured Constant Ratio) re-surfaced in the 1930s, when investors and institutions were questioning how they could have been so stupid as to go into 1929 overladen with stocks.

The Variable Ratio Formula is discussed among others, in books by Benjamin Gaham and William Bernstein.

If it helps on a personal level, because we have no special insights into market directions or forces, our Major Asset Class Weightings are by Variable Ratio determined by real yields, Regions by Constant Ratio, Individual Positions by Constant Value (generally rising).

Real Yield is allegedly a broken measure (Smithers), but we find it most helpful if adjustments made from decade to decade.

@Sarah — I’ve been trying to get back into reading fiction. I managed it with “A Little Life” recently, which is gut-wrenching although less impressive the more it goes on. I’ve just been up to my eyeballs in company reports / investing / science literature for the past 3-5 years! 😉

@SirGordolot — Well, it was from The Guardian, and to be fair the author did say at the end he wasn’t actually against these particular shelters. I think we’re very confused about wealth creation in this country at the moment.

@Mike — You’re welcome. Seems to have been popular, judging by the requests for the spreadsheet. (Have you considered sharing it with Dropbox or similar?)

“to clamp down on Panama Paper style antics”: much as I dislike Cameron, I can’t see that he did anything wrong. He invested in a company. He sold the shares at a profit, which he declared on his tax return. What the devil is an “antic” about that?

@SirGordalot: I don’t have any particular issue with the various savings protections being highlighted as a benefit for the upper-middle class. We’re living in a time where anyone on below average incomes is seeing government support taken away, especially under 25s, and it seems extraordinarily to be giving savings perks that only people capable of putting £20k+ into savings (in addition to whatever their pension contribution is) at the same time; and I’m saying that as someone who overpays into their pension and will use our ISA allowances.

The difference in return over those two 50yr periods is due to the valuation in 1966 being in bubble territory. A bubble that came to a sickening end in 1972. On my own model it was 65% high at the time. This elevated the first period growth and suppressed the latter. Correcting for this would give both periods showing 6.5%pa… right on the very long term average.

You should ignore any analysis based on an arbitrary selection of dates. The conclusions are quite worthless… in fact, dangerous.

Correcting for this would give both periods showing 6.5%pa… right on the very long term average.

You should ignore any analysis based on an arbitrary selection of dates. The conclusions are quite worthless… in fact, dangerous.

Of course, your 6.5% p.a. very long-term average is also based on an arbitrary selection of dates, with a start and end date too, so presumably it is both “quite worthless” and indeed “dangerous” by your own definitions. 🙂

I happen to agree with you that caution and awareness is warranted — as indeed I highlighted in my article.

However it’s better to be aware than hyperbolic. The data isn’t worthless, it gives us information that we can combine with other information to draw conclusions (which is what you’ve done with your feeling that 1966 represented with the benefit of hindsight — although you don’t say that — a bubble).

@paul — Fair enough I’m not going to split hairs about the fitted trend line. I doubt you’re fitting it back to the 1500s or even the 1800s. Trend lines can move depending on what you put into them. Damned lies and statistics! 🙂 But as I say, I don’t have a problem with looking at data over any period, I’m not going to quibble over data I can’t see, and on the face of it your response does sidestep my initial thought, from your use of “very long-term”, which was that you were just looking at say the Barclays study from 1900 to 2015 or similar.

But to the second point, no, I don’t think that 1966 could definitely be seen as a bubble. I do think that is hindsight speaking. I think it could very probably have been seen to be *likely* overvalued (and I’ve read for instance all Buffett’s letters from the period as he gets increasingly worried). If you’re an active investor, it would have been fair to take humble but appropriate response.